Understanding Basic Accounting

Many small businesses hire an accountant to take care of their books.  If you can afford it, that’s usually a good idea because time is your most valuable resource and should be spent actively running and managing your business.  It still makes sense to have an understanding and appreciation of what your accountant is doing for you.  This will help avoid surprises and allow you to talk intelligently about financial decisions that affect your bottom line.

In the old days, accountants often wore green eyeshades to reduce eyestrain caused by early incandescent lights.  Their handwritten ledgers have been replaced by computer software that can produce instantaneous reports and statements.  The purpose of this article is to provide a basic understanding of the accounting process.


Journal Entries


The first step in the process is recording journal entries that are triggered by business transactions.  Today, few transactions are conducted with cash exchanging hands which has made recordkeeping much easier.  Most business transactions are done on credit, usually through a line of credit or credit card.

In accrual accounting, transactions are recorded when they happen, not when they are actually paid for.  So when you purchase something on credit, the transaction occurs at that point, not when you pay the bill later on.

A journal entry consists of a debit and credit to at least two different accounts.  Assume that you use a credit card to buy $100 worth of office supplies.  One journal entry would be a $100 debit to the supplies account since you have increased your assets by that amount.  The other journal entry is a $100 credit to the accounts payable account since that amount is now a liability owed to your credit card company.  Note that the debit equals the credit entry, so they balance to zero.

General Ledger

Company transactions are recorded in a general ledger as journal entries.  It will show changes in each account and is normally reconciled monthly.  Traditionally, accountants created a “T” summary for each account, with the name at the top and two columns on either side of T-stem.  The left column lists all the debits and the right column lists all the credits. 

The information from the T accounts is used to create the trial balance.  This is a table that lists the balances of all the asset accounts, and the equity and liability accounts.  Asset accounts normally have a debit balance: buildings, land, equipment, cash, inventory, accounts receivable, etc.  Equity and liability accounts normally have a credit balance: owner’s equity, mortgages, outstanding loans, accounts payable, etc.

The trial balance should reflect equal totals for debits and credits.  During certain accounting periods, adjustments are made for items such as prepaid expenses and depreciation.

Financial Reports

One benefit of being a sole proprietor is that you can dictate the types and frequency of reports you want and need to track your business.  At a minimum, you’ll need financial data that’s necessary to complete your annual tax returns.  For most small businesses, monthly reviews of your financial status are adequate.  You don’t want to wait longer than that to spot problems and take corrective actions.

Depending on the legal structure and organization of your business, you may be required to produce financial statements on a regular basis.  For corporations, this is usually quarterly and consists of a balance sheet, cash flow, income statement, and accompanying notes:
  • Balance sheet – Shows who owns the company (stockholders’ equity), what the company owes (liabilities), and what the company owns (assets).  Remember this simple formula: Assets = Liabilities + Stockholders’ equity
  • Cash flow – Summarizes changes in cash position during the year
  • Income statement – Displays the revenues (sales) and expenses that were experienced during the reporting period
  • Notes to statements – Contains explanations necessary to understand and analyze the statements, as well as details regarding company accounting methods
The process is completed when the accounts are closed and reset for the next reporting cycle. 

Accounting Guidance

The Financial Accounting Standards Board (FASB) establishes private sector standards for financial accounting.  The standards are recognized by the Securities and Exchange Commission and the American Institute of Certified Public Accountants.

The FASB sets generally accepted accounting principals (GAAP) primarily through its Statements of Financial Accounting Standards.  These statements provide the highest level of financial guidance and are sometimes expanded upon by other FASB pronouncements.

Summary

Understanding your finances is critical to successfully running your business.  Computer automation has made this much easier and faster than ever before, so take advantage of the software programs available to track your status.

Your customers, suppliers, and lenders are counting on you to keep accurate financial records.  If you don’t, they’ll go elsewhere with their business.  Whether you use a CPA or not, you still have a legal and ethical obligation to maintain the integrity of your finances.  It will also make dealing with the IRS a whole lot smoother.


Geoffrey Michael is a freelance writer specializing in business, marketing, personal finance, law, science, aviation, sports, entertainment, travel, and political analysis.  He graduated from the United States Air Force Academy and is also licensed to practice law in California and New Hampshire.  Geoffrey wrote this feature article exclusively for Debbie May.com (www.DebbieMay.com), an organization dedicated to helping small businesses succeed.